Good day and welcome to the Q2 Fiscal 2022 Key Tronic Corporation Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Brett Larsen. Please go ahead, sir.

Thank you. Good afternoon, everyone. I am Brett Larsen, Chief Financial Officer of Key Tronic. I would like to thank everyone for joining us today for our investor conference call. Joining me here in our Spokane Valley headquarters is Craig Gates, our President and Chief Executive Officer. As always, I would like to remind you that during the course of this call, we might make projections or other forward-looking statements regarding future events or the company's future financial performance. Please remember that such statements are only predictions. Actual events or results may differ materially. For more information, you may review the risk factors outlined in the documents the company has filed with the SEC, specifically the latest 10-K, quarterly 10-Qs, and 8-Ks. Please note that on this call, we will discuss historical financial and other statistical information regarding our business and operations. Some of this information is included in today's press release, and a recorded version of this call will be available on our website. Today, we released the results for our quarter ended January 1, 2022. For the second quarter of fiscal 2022, we reported total revenue of $134.5 million compared to $128.3 million in the same period of fiscal year 2021. Revenue for the second quarter of fiscal year 2022 related to customer reimbursements for tooling, equipment, and other expenses increased approximately $10 million, when compared to the previous year. For the first six months of fiscal 2022, total revenue was $267.2 million, compared to $251.5 million in the same period of fiscal 2021. During the second quarter of fiscal year 2022, the global supply chain, pandemic, and transportation issues continue to disrupt production, including intermittent parts supply, factory downtime, and overtime expenses. In addition, we had a seasonal closure for two weeks at the end of December in our Mexico facilities that limited production time available for the quarter. Legal costs related specifically to the SEC’s review of last year’s whistleblower complaint totaled approximately $0.7 million during the quarter. For the second quarter of 2022, our gross margin was 7.3%, and operating margin was 1.2%, compared to a gross margin of 8.3% and an operating margin of 2.1% in the same period of fiscal year 2021. Note that revenue attributed to customer reimbursements during the second quarter of fiscal year 2022 did not contribute much to our gross margin. For the second quarter of fiscal year 2022, net income was $0.6 million or $0.05 per share, compared to $1.6 million or $0.14 per share for the same period of fiscal year 2021. For the first six months of fiscal year 2022, net income was $1.4 million or $0.13 per share, compared to $3.3 million or $0.30 per share for the same period of fiscal year 2021. Turning to the balance sheet. We continue to maintain a strong financial position. As a result of supply chain related production delays in the second quarter of fiscal 2022 and the continued ramp and transfer of new programs, our inventory turns decreased from the prior quarter. We are carefully balancing customer demand and the likelihood of successfully bringing in parts in time for planned production. The production planning now requires that we look out much further in the future than in historical periods. In future quarters, we expect to see our net inventory turns to be more in line with the expected revenue as efforts to mitigate the impact of supply chain issues begin to yield improvements and new production programs begin to ramp. At the end of the second quarter, trade receivables were down about $3 million from the prior quarter, reflecting the timing of shipments and improved collections. Our DSOs remained about 83 days, the same as in the first quarter, which reflects both timing of shipments during the quarter and some delays in payments from customers, who were also impacted by the pandemic-related slowdowns and restarts in their respective markets. Overall, our balance sheet has total working capital of $176.4 million and a current ratio of 2:1. This is down from the prior quarter, largely due to growing customer production requirements and onboarding new programs. Total capital expenditures were about $1 million for the second quarter of fiscal 2022. We're keeping a careful eye on expenditures during fiscal 2022 and expect our capital expenditures for the full year will be around $6 million. We plan to continue to invest selectively in our production equipment, SMT equipment and plastic molding capabilities, as well as make efficiency improvements in our facilities to prepare for growth and add capacity. Despite growing customer demand and new program launches, we expect the delays in the supply of key components will continue to limit production and adversely impact operating efficiencies. For the third quarter of fiscal 2022, we expect to report revenue of approximately $130 million to $140 million and earnings of approximately $0.05 to $0.10 per diluted share. We're working closely with our customers, key suppliers, and employees to minimize the effects of delays attributable to the continued global pandemic, increased global freight and logistics costs, and limited availability of key components. While our facilities in the U.S., Mexico, China, and Vietnam are currently operating while following current health guidelines, uncertainty as to the possibility of future temporary closures, customer fluctuations in demand and costs, future supply chain disruptions during the rapidly changing COVID-19 environment, and other potential factors could significantly impact operations in coming periods. In summary, we continue to see increased demand and new customer wins, improving our total backlog. However, supply chain disruptions and the pandemic continue to impact our business during the second quarter and remain risks in future periods. However, we are encouraged by our growing backlog and by our prospects for future growth. New sales prospects and recently won programs continue to increase our customer demand to unprecedented levels for Key Tronic. The overall financial health of the company appears strong and we believe that we are increasingly well positioned to continue to win new EMS programs and to continue to profitably expand our business over the longer term.

Okay. Thanks, Brett. While we continue to face the stiff headwinds from worldwide supply chain challenges in the pandemic, we're pleased with the successful ramp of new programs and our expanding customer base in the second quarter of fiscal 2022. During the second quarter, the industry continues to face persistent worldwide shortages in the supply of key components, particularly for electronic parts. These shortages have extended production timing and cause transportation costs to triple. Had it not been for the supply chain issues, we believe burgeoning customer demand would have driven revenue for the second quarter in excess of $160 million. Unfortunately, we do not expect the supply chain disruptions to improve significantly in the near term. We also struggled with increasing labor costs and shortages of production staff at some of our sites, as part of the industry-wide labor shortages. In the face of all these challenges, we continued winning new customers and ramping new programs. During the second quarter, we won new programs involving industrial robots, lighting control, disinfection, food production, and energy management systems. We also announced a significant new program win with one of the world’s leading power equipment companies for which we expect to begin manufacturing in the first quarter of fiscal year 2023, and once fully ramped could contribute approximately $80 million in annual revenue. We were selected in large part because of our design and manufacturing expertise to help them accelerate the introduction of new products, as well as to enhance their ability to increase product availability to fulfill demand. This new relationship represents an important expansion of our customer base. We would not have won this many new programs without our design capabilities and our multi-region footprint, which is designed to be the ideal solution to our customer supply chain issues. During the second quarter of fiscal 2022, we saw a significant increase in production across our U.S.-based facilities. In fact, over the last three quarters, our Midwestern facilities have won business, which we expect will result in an increase of over 35% in annual revenue generated by those facilities by this time next year. Moreover, production at our new Vietnam facility continues to grow, and we expect big savings from our Da Nang facility in the future. As we've discussed on previous calls, the pressures on our customer base to lessen their Asian supply concentration remain very powerful. Demand for North American production continues to grow with no foreseeable end to tariffs, intensifying political tensions between China and the U.S., increasing Asian production costs, and time to market, and a weakening U.S. dollar. These factors have driven a significant increase in our business. Key Tronic has emerged as the ideal answer to the overconcentration of Asian supply and for onshore into North America, particularly for those companies with programs in the range of $5 million to $100 million. We provide everything needed to make supply chain diversification easy, less risky, and less costly. Our solution set provides companies with both local sources for low-volume products and low-cost sources close to the geographic markets for higher-volume products. We also attract companies that have been overly concentrated with an Asian source and hence have more likely lost engineering control. We can facilitate the move of production from a competitor to our site, enabling the smooth transfer by providing design and production engineering services to those companies who no longer have the capability. Our vertical integration can lessen the risk, time, and cost involved in a transfer. Moreover, after a decade of developing custom processes for a staggering array of products, we can onboard just about any product imaginable. Moving into the third quarter of fiscal 2022, significant uncertainty still surrounds the continuing disruptions to global supply chains for key components and the threat of the pandemic. At the same time, we believe that these challenges will continue to force our customers to weigh carefully the degree to which they concentrate their supply chain in any one region and relinquish design control to their outsource partner. The recent macroeconomic events continue to force many companies to more fully recognize the significant impacts an elongated supply chain can have on both cost and availability, the risk of IP appropriation, and the attractiveness of doing business with an outsourced partner who can minimize their risk and all of these factors. These market trends and our capabilities should continue to power our growth over the long term. This concludes the formal portion of our presentation. Brett and I will now be pleased to answer your questions.

Thank you. Our first question today comes from Bill Dezellem with Tieton Capital.

Hi. Thank you. So in the release, you noted the six new program wins, one of which was $80 million annual revenue, congratulations. The other five, how would you characterize the size of those please?

From $5 million to $15 million per year.

For all five of those.

Yeah.

Great. Thank you. And then, would you characterize the supply chain situation in more detail than you did in your opening remarks, and maybe how it changed over the last quarter where you're at today? And I'd love to ask kind of when you see this returning to normal, but maybe just what you see coming maybe just the more appropriate question?

There are two aspects to that question that are important for our outcomes. One consideration that often gets overlooked in our business is how our customers are understanding the situation. Over the last year to year and a half, we have moved from denial and anger to acceptance and a willingness to plan and address the current challenges. Customers are now generally more willing to provide us with longer-term binding forecasts for component purchases, and they are quicker to agree to short-term price increases when components are available on the gray market. Previously, about two-thirds of our orders would go unfulfilled because customers took a long time to decide whether to pay significantly higher prices for components. Thankfully, this situation has improved. On the other hand, there is also a third aspect regarding how customers are coping with ongoing price increases. While we have been more successful in justifying price increases, initially it was difficult to convince customers of their fairness. However, as inflation has become widely recognized, many customers are now experiencing their own hiring challenges. This understanding has made that aspect of the equation better, not due to an actual change in conditions, but because customers have become more accepting of the situation. Regarding component availability, I would say it has stabilized, though not in an excellent way. Lead times are still around a year to a year and a half, and while they have not continued to worsen, there are still occasional surprises when shipments are delayed unexpectedly. Overall, I wouldn't say the supply chain situation has improved, but it has stopped deteriorating. As for when I expect things to return to normal, I honestly don't know. There are many unpredictable actions from politicians, such as making ships in the LA Harbour sail around to improve appearances from the air, which adds to the uncertainty.

Thank you, Craig. Do you see in the next, let's say three months between now and when we talk next that this is going to continue in this stabilized mode, or do you feel like we are at a bit of a transition where we could see a modest improvement begin in the next three months?

I think you have to be optimistic to say it's not going to get any worse and is going to be stable for a while. I certainly wouldn't predict that it's going to get better in the next three months.

We are seeing revenues increase from $130 to $140. However, the $134 you achieved this quarter included some customer reimbursements. Is this uptick due to components ordered months ago finally coming together, or is it a result of products being built that have shorter lead times?

It’s more like a three-sided teeter-totter, which I started using as an analogy, and I’m sticking with it. For this quarter, for the first time since everything began, the numbers we're projecting are looking good in terms of parts arriving as planned. In the last four or five quarters, we were hoping for confirmed parts that didn’t come through. Now, we're able to look ahead about two quarters and see that if we miss our targets, it will only be due to an unexpected issue. In the past, missing our targets could have been due to unexpected problems or anticipated confirmations that fell through. Does that clarify the difference for you?

It is. So if I'm hearing this right, your guidance is more conservative this quarter, because you have been given, I’ll call them promises that the components will be there. And the only reason you would miss the revenues is if those promises don't come through, whereas in prior quarters, you had made some assumptions; sometimes your assumptions were accurate, but if they weren't then that was a revenue risk?

I wouldn't necessarily say it's more conservative because we're trying to follow the same approach whenever we provide guidance, but the circumstances have evolved. Perhaps there's slightly less variability now. The standard deviation may have decreased a bit, although we are still operating within our confidence levels. That's why I attempted to explain the volume aspect, as I don't think labeling it simply as more or less conservative accurately captures the situation.

No I think I am understanding. Thank you. Let me switch, if I may, to the U.S. facilities, and you mentioned that they had a good sales increase. How much were their sales up in this quarter versus the year ago fiscal Q2?

Not much; they've been pretty flat for a long time, probably three years.

And so this increase that you are anticipating and the business that they are winning, that's a meaningful change in what's happening with those facilities?

Definitely.

Hey, I'll ask one more question and then get back in line. So what in your mind has changed leading to the, what I think 35% or so anticipated revenue growth with the U.S. facilities?

Everything we've discussed has materialized. It took a year and a half for people to understand that the risk in the Asian supply chain was going to persist. During the first year, the Biden Administration recognized that the political situation in Asia was not exclusive to their administration; it reflected a broader awareness of current economic uncertainties. After realizing this, it takes time for people to assess the market and recognize that Key Tronic is ready and welcoming. Once they understand this, they require additional months for quoting and site tours. This aligns with what we anticipated would happen. The key question for us is whether this momentum will continue or if we only attracted those most eager for solutions, which might lead to a return to a steadier growth rate. I believe the growth will persist, but I might be biased.

No, that’s helpful. We appreciate your perspective. I'll get back in line.

And our next question will come from Bill Dezellem with Tieton Capital.

All right. I guess I got in the back of a line of zero. So let me continue down the path, if we could, in a normal environment, assuming that one day we do return to that and you have $130 million of revenues. Would you agree with this math that essentially your SG&A and R&D would be similar, except you would not be paying $700,000 to Lauriers for the inventory SEC thing? And you would have roughly 9% gross margins and otherwise and 25% tax rate, and that would ultimately lead you to something like $0.23 a share as a pinpoint number, but let's just call it $0.20 to $0.25 a share of earnings in a quarter or working up between $0.80 and $1 per share for the full-year at the $130 level, is that essentially a correct assessment of the business model or am I missing some important swing factors?

I think you understand it well. However, it's important to note that we can't guarantee this outcome. With an inflation rate of 7%, we need to successfully transfer those costs to our customers. If McDonald's continues to close locations due to staffing issues, we won’t be able to find enough workers to meet our needs. If we assume all those challenges are resolved and we return to normal, then your projections would hold true.

All right. I recognize there are some what used to be easy assumptions, and they seem a little more lofty these days. Let me take this one step further, I think, Brett, you had commented that you're at unprecedented demand and you were at greater than a $160 million of demand which would be meaningfully above the $130 million that I just used with my simple math. Is it a correct assessment that there are some economies of scale, meaning that the business model, again assuming away all of those factors that are difficult at the moment to assume away, but that you would then have some leverage in the business model on the SG&A and R&D side and frankly, maybe even the gross margin side?

I would suggest that while that might be the case, it's not necessary to make any of those assumptions in order to arrive at profit numbers that are quite impressive. If you can achieve $160 million in revenue per year, which translates to a quarterly figure.

Understood. No, I’m totally in alignment. So I'll take the bait and ask what is it going to take to reach that $160 quarterly revenue run rate? Do we just need to wait for some time to pass because you've already ordered parts at these levels, and so it's just simply a matter of time, or are there other factors that need to be taken into account?

Remember, it's not just parts, it's people. Yes, you can order people ahead of time. So that's the big issue is, what's going to happen with the labor supply in the States and in Mexico, as well as the componentry.

Thanks for the reminder. It’s easy for me to focus on just one issue. Is there anything else you would like to add to that?

No.

All right. Well, we will anxiously await you ordering the parts and finding the people to generate that $160 million of quarterly revenue.

Not quite as anxiously as I will be, but we will be in this together.

Let's turn our attention to Vietnam. I haven't been keeping up with their COVID lockdowns, which I know have been quite strict. Can you provide an update on the situation there and share how both your existing customers and any new potential customers view moving products into your Vietnamese facility?

Okay. I'm going to answer a question that you should ask too along with this. The Vietnam situation is still tightly locked down even though they are have opened up the actual paperwork and testing and everything required to get in there is still really, really hard to get passed. So it's going to be, I think, another quarter or so, depending on what happens with the next strain of COVID before we can actually start to unlock all of the potential of Vietnam. The programs that are they're running great. We have won a couple of programs with our customers actually giving us business there without ever actually seeing the site other than on video tours. So we continue to believe that Vietnam has a really good future; it's just we can get people in there yet to add new business. The question you didn't ask is the future of our Shanghai operation, which is also pretty encouraging. We have never really been able to crack the code of China business built in our Shanghai plant to stay in China. And over the last year, we've won a number of new pieces of business. One of them, we announced in this quarter that are going to be built in Shanghai and shipped to a Chinese factory, and we’re one of the business development was performed by people in our Shanghai facility. So that's one of about four new business wins there over the last three quarters that are hugely encouraging to us for the future of the Shanghai plant too.

Craig, what has changed to lead to that, because I have had historically been under the assumption that China was producing for somewhere else in the world. Not producing for China, or I should say your Shanghai facility?

Yeah. That's been the case, and we've had to make quite a few operational and procedural strategic structural changes to the way we run Shanghai to make it a viable competitor for Chinese business. There are a lot of unique requirements for the Chinese market that you can’t fulfill from the States, so we've made those changes, took risks, and it turned out to be successful.

Congratulations. Let me switch to a different angle on that. I haven't thought of before, so apologies for this question maybe not being well thought out, but given the amount of business that we hear about moving away from China, that seems as though it would lead to excess or at least additional capacity being available in China. With that in mind, why have you won four different program wins with my theorized additional available capacity probably by Chinese firms?

Well, I don't want to be flip, so I'll just say, it's a very good facility. We've been running it for over 20 years. It's backed by the design team here at corporate, so there are some attributes that our Shanghai facility has that are not all that common on the competition in the competitive landscape in China.

That's helpful. And so are these four wins for Chinese companies selling in China, or are they for companies outside of China that want to build in China to sell in China?

Both.

Excellent. I'm going to ask another question since the line didn't seem to be very long sorry, the queue, and you are welcome to kick me off if you would like here at any point. The customer reimbursements that you referenced, I think this is the first time that we've seen that called out in one of your press releases, would you discuss kind of what the dynamics there are and what's different now?

Well, that's completely a result of new business wins that then require custom tooling to be made, designs to be completed, and customer equipment to be purchased, and all of that is reimbursed for us by our customers. So that's why there is not much profit on it, but it's a harbinger of production to come.

So we should view this as a very favorable indicator of the future.

Of the long-term future, yeah, because these programs, they're big. So the $80 million one won't start production until late summer, but tooling is already being purchased and equipment is already being purchased that will be used in the ramp of that program at the end of the summer. And that's not the only program that was in that bucket of reimbursement for tooling equipment.

And is it fair to say that any customer who is going to spend money on tooling ends up being pretty serious, and I mean they're moving forward? And I'm really trying to contrast this to, I think what’s pretty well known in the industry as more program wins than actual new business that ramps somehow or just ends up disappearing?

Well, for sure, if somebody plugs down $5 million for tooling, it means that they have every intention of using that $5 million of tooling.

Thanks for your understanding. I’d like to move on to the customer who is spending $80 million.

Before you before you do that, there is kind of a foster child case that's going on that as another chunk of change in that, it’s actually $20 million of customer reimbursements last quarter in total. And this is a customer who had for years purchased their product out of China and actually had little to no manufacturing and engineering expertise. So that program will take us probably two years to move into our facility in Juarez. In that case, the customer is actually backstabbed us for a lease on another 100,000 plus square feet. We’ll be purchasing close to $10 million worth of specialized equipment to build that product, and we’ll spend a year learning with us how to build their product since the people who knew how to build it have kind of drifted off as their production was more and more in China. This is kind of a foster child for a number of opportunities that we're in the midst of hopefully finalizing with companies like that. Who are in essence branding and ideation companies that need a partner to replace what has become too risky with their supply chains spread out across the world. So that's why I say it's a long-term upside when you see a big investment happening with us. It could be a two-year lag between the time they spend $10 million and the time we start cranking out product.

That's really helpful. Thank you. You mentioned that you're hoping this is one of the first opportunities, and it sounds quite large. If you're investing $10 million, that's a relatively small amount. Are the other opportunities you are pursuing similar in size, or is this one unusually large?

I would say they tend towards that size.

Essentially, the customers who find it important enough to invest in equipment for their contract manufacturer are typically larger. They also tend to be more committed once they increase their operations.

They are definitely more committed, and it's evident that what we've developed in the company becomes their primary solution when seeking a partner for an $80 million project. We have the experience of handling a range of products, from toilet bowl cleaners to slot machines, along with over 15 years of successfully relocating projects from Asia to the U.S. Our design team collaborates effectively with their ideation group to bring their concepts to life. Additionally, we have the expertise to reassemble the necessary data and knowledge from the soon-to-be former Asian source to develop the product. When you assess all those qualifications and analyze the competition, Key Tronic is essentially the only option available.

And so if that's the case, as opposed to just a supplier, you become more of a partner. Is that a fair speculation?

You bet.

We look forward to seeing that develop and maybe that's a good segue to the $80 million win that you announced with the power equipment company this quarter. Would you walk us through and how has that developed and why you were the one who was ultimately chosen?

It's a good example of a project where the company initially hired a consultant to help them find someone because they were struggling to do it themselves. They required design capabilities in both metals and plastics, along with skills in tooling, acquisition, and design. They needed immediate specialists who could navigate the commodities related to metals and plastics and other areas I'm not going to specify to keep it discreet. It took a year for both teams to get familiar enough with each other to develop a successful plan for them and their end customer. This will likely be a long-term program because it will be challenging to find another company like ours to fulfill this need in the future.

And you said this one is going to begin in the summer.

Late summer.

Late in fiscal Q1.

Yeah.

And how would, as you currently envision, the ramp to take place? How do you go? What's the slope of going from starting late Q1 to one year at a full $20 million per quarter run rate?

Again God is punishing us by answering our prayers. So it's a steep ramp.

Since I just sit behind a desk and don't actually do any real work, there is a steep ramp mean that by the December quarter, you're at $20 million or is a steep ramp over the course of the year?

No, a steep ramp is over a quarter.

So literally is the September quarter you could start producing albeit at a $20 million revenues from that customer in the December quarter.

So we're hoping.

Excellent. Well, I think I will leave it there because that takes us pretty darn close to that $160 million that we talked about earlier. Thanks for taking all my questions.

You bet. Thanks, Bill.

And our next question comes from George Melas with MKH Management.

Hey, guys.

Hey, George.

And thank you, Bill, also for your great questions. It’s always a pleasure to listen to. Just a quick question on CapEx. CapEx was relatively low this quarter and I think that you said you guys, Brett, I think you said you expected it to be $6 million this fiscal year, which I think is a slight tick down from the previous forecast. And on this strong revenue growth, it seems CapEx is coming down. So it's something is working right there? Can you sort of explain that?

Yeah. I think we've mentioned previously, George, that we've got capacity, and we're also, as Craig mentioned, being reimbursed for program specific equipment. So the combination of those two things, we're monitoring it closely, but our intent is to have less CapEx this year and see some revenue growth.

Okay. And you expect that to continue in fiscal ’23, or is it too early?

That's too far, George. I mean typically, we're spending $8 million to $10 million per fiscal year in CapEx. My expectation is that it would return to something close to that in the next fiscal year.

Okay. And then just to understand the reinvestment this quarter, what have they been in the past few quarters, in the last three or four quarters?

Not that high. That was one of the reasons why we disclosed. The year-over-year change is that this quarter in particular was significantly higher than even some of the sequential quarters that we've just gone through.

Is it right that it was roughly $20 million and it's roughly $10 million higher than a year ago?

No, it's roughly $10 million higher than it was a year ago. In any one particular quarter, it will range from $5 million to $10 million.

Okay. Can you say just how much it was this quarter, just so we can understand that?

Just over 15.

Okay. So if we sort of normalize for that, it means that we can see sort of the production delays and issues with being able to produce as we act that out?

Yes.

Okay. That’s it from me. Thank you, guys.

Thanks, George.

Thank you. Our next question comes from Sheldon Grodsky with Grodsky and Associates.

Good afternoon, everybody. I have a few questions, but they'll be quickies. When do you expect your legal expenses to disappear regarding the inventory issue?

We have no comment on that.

Okay. Great. Okay. I noticed that your average shares outstanding went down for the quarter. Is that just because the stock price went down or did you buy back any shares?

We did not buy back any shares.

Okay. There was a big jump in inventories, I guess, partly because we're able to get something, but are you holding any inventory at this point?

No, no, you want to buy. So we are not holding. This is all a result of being able to get all but one part, and then we can build the product, and all the rest of those parts sit there unused.

So there is a bad reason for having that, okay. And one more question, when your customer reimburses you for the equipment, is it going to be his equipment or equipment? When the project is done?

It will be his equipment when the project is done. But historically, by the time the project is done, the equipment is all used up anyway.

Okay. That will be it for me. I just have a few quick issues.

Okay. Thank you.

Thank you.

Thank you. And that does conclude the question-and-answer session. I'll now turn the conference back over to you.

Okay. Thanks again, everybody for participating in today's call. Brett and I look forward to talking to you again next quarter. Bye-bye.

Well, thank you. And that does conclude today's conference. We do thank you for your participation. Have an excellent day.